When inflation hits, central bankers get scared. They fear inflation as much as they fear deflation, and would go to great lengths to bring inflation under control, even if it means risking an economic recession. This explains the reaction of the Federal Reserve of the US, the Bank of England and the European Central Bank.

The Federal Reserve has been the most aggressive in raising interest rates, just as it was the most aggressive when it came to reducing interest rates and implementing quantitative easing. It implemented a loose monetary policy to get the US out of the credit crunch, the crisis in the financial markets and the resulting economic recession a decade ago and is fervently adopting a tight monetary policy to overcome the challenge posed by inflation.

There was a time when central banks were taking the necessary steps to push inflation towards the target of two per cent. Now that it has been surpassed in a significant way, they want to slow economies down. Governments did not do much to stimulate the economy because of the high (and in some cases unsustainable) level of public debt they had, and allowed the economy to move on the basis of cheap money.

The era of cheap money is now dead. Many governments did not implement the structural economic reforms they needed to implement. Then came the coronavirus, and with it, a significant slowdown in economic activity. This indebted governments even more, and with them, businesses and individuals. So they are now caught again on the wrong foot.

The question that economic analysts are asking, and for which there does not seem to be a ready-made answer, is whether the increase in interest rates announced by central banks is enough to cool the economy, without plunging it into a recession. Can governments take any measure to control inflation?

As a friend of mine put it to me over the weekend, are we back to where we were in 1974, facing the spectre of stagflation (economic stagnation + inflation)?

Before determining any economic policy measures, there needs to be a common understanding of what has caused this inflation. Cheap money was definitely a contributor, as was government support during the coronavirus period. Unfortunately, the money supply that was pumped into the economy was not supported by increased economic activity and increased productivity.

When an economy goes through a period of subdued economic activity, it should not be experiencing inflation. However, cheap money and wage support, which were both much-needed measures, ensured that demand remained buoyant. An activity that appeared to generate wealth, wherever it came from and whatever shape it was, was welcomed.

Then there are also elements that are outside the control of governments and which are also leading to higher inflation. A case in point is the prices of commodities; another case is supply chain disruption. Are these two elements really out of governments’ control? Can governments ease supply constraints and can governments control the price of commodities through some form of price agreements?

In the meantime, we have to learn how to live with higher interests again. How high they will go remains to be seen but they may very well rise to four per cent, with lending rates being at least three per cent above that. Governments should also consider intervening with lending rates, especially those relating to housing, but certainly not those relating to discretionary consumer spending.

Governments cannot let central banks walk this tightrope alone and there needs to be coordinated action between the two

A cooling of the economy would certainly be most welcome. However, a recession would not be welcome. Governments cannot let central banks walk this tightrope alone and there needs to be coordinated action between the two. Otherwise, we risk a general impoverishment of most of the population in most countries.